Adapting to the changes in later life advice and retirement incomes

Headlines:

1. Client income needs in retirement may not follow the classic “retirement smile”
2. New IFS research suggests client spending in retirement doesn’t reduce as much as might be expected as retirement progresses
3. With inflation on the increase, modelling and managing retirement outcomes has become even more difficult, but advisers feel this just increases the benefits of advice through being able to coach clients on income management
4. With interest rates rising again, it may be worth thinking about how annuities figure in retirement plans
5. Advisers are increasingly looking to equity release to support intergenerational gifting and efficient income management

Discussion points:

What do clients need in retirement?

Client income needs in retirement are often referred to as the "retirement smile". That is, clients will tend to want more income in the early years of retirement, but this reduces as they become less active and then increases as the costs of healthcare, and perhaps long-term care, have to be covered.

Canada Life presented new IFS research¹ they had co-sponsored which seemed to contradict this and points to client income needs remaining more consistent throughout retirement. It was suggested that, while that conclusion might be correct at an average level, advised clients were less likely to be financially constrained in their spending. Most agreed that health was the real determinant of how much advised clients tended to spend, but that needs varied significantly. Another distinction is that spending needs may be relatively constant, but with State Benefits increasing at, or above, inflation - and people being willing to work longer - this could translate into a variable need for income from private savings.

 There was also a recognition that people tended to want to maintain a similar lifestyle in retirement to that they enjoyed while working. Those with significant wealth aren’t likely to go on a spending spree in retirement and those with less retirement savings will aim to maintain their lifestyle for as long as they can afford to do so.

Factoring inflation into retirement needs:

It’s fair to say that market conditions have been pretty kind for drawdown investors in recent years. While we did see a big downturn at the start of the pandemic, it was short-lived. Moreover, lockdown meant that people’s income requirements also fell sharply, reducing the need to access savings. However, we’re now in the opposite position with cost-of-living increases pushing spending higher just as portfolios come under pressure. Clients who haven’t had to worry too much about spending may now be having to make a budget for the first time.

As if there wasn’t enough uncertainty in retirement, with client longevity and investment returns having to be forecast, we now must think where inflation might go. There are multiple practical challenges with modelling this. What inflation assumption does one use? Obviously, assuming a higher rate overall may be overly prudent and not recognise the action that will be taken to bring inflation under control. Additionally, we have to think about what market returns are consistent with renewed inflation. To what extent can we, and should we, assume higher inflation will eventually feed through to increased returns? The reality is that many modelling tools don’t make it easy to model temporary increases in inflation or necessarily correlate inflation and investment returns.

But, never deterred, some advisers see this increased complexity as further justifying the benefits of financial advice. Many have already started having conversations “coaching” clients on how to manage income through the current environment. The focus for advisers should be on managing expectations. With the use of cash buffers near universal, the hope is that many clients will be able to weather the markets in the near term. The reality is though, if markets are going to deliver lower returns than expected, clients will ultimately have to reduce spending. Making sure clients are prepared for this is essential.

What role for annuities?

With interest rates rising again, it may be worth thinking about how annuities figure in retirement plans.

Low interest rates and a favourable market environment in recent years have led many advisers to conclude that the growth potential and flexibility of drawdown far outweigh the benefit of income certainty delivered by annuities. Annuities certainly remain relatively inflexible, and their fixed payments could see their value eroded by inflation. However, rates have risen significantly in the past few months with the level annuity rate for a healthy 65-year-old now approaching 6% again. Older investors and/or those with health conditions could see rates significantly higher.

 Having some element of guaranteed income may help clients reduce the strain on their savings during depressed markets. If the guaranteed income is purchased within the SIPP, then overall income can still be managed tax efficiently. While it still may be better to consider annuitisation later in life, once any medical conditions have emerged, the rapid improvement in rates means that annuities at least have to be considered as a viable income option again.

Equity release coming of age?

Advisers are increasingly looking to equity release to support intergenerational gifting and efficient income management. Equity release has seen a significant increase in activity this year, having hit a record of around £4bn of lending in 2021. While many will access housing equity out of necessity, it appears that more advisers are looking at it to better manage retirement planning.

Canada Life demonstrated how accessing equity earlier in retirement could not only improve the efficiency of income but also help maximise overall inheritance by using the pension as the most tax-efficient vehicle for passing wealth between generations. Equity release could also be used by those clients with Buy-to-Let properties looking to repay interest only mortgages.

Key takeaways:

• Retirement advice is arguably the most challenging area of financial planning
• Pension freedom presents myriad opportunities to help clients optimise the efficiency of the income they take and maximise what they can pass on to future generations
• The sharp rise in inflation coupled with weaker markets has introduced additional uncertainty to the process and advisers may find that the traditional approach to structuring retirement plans using just invested assets is coming under strain
• By combining annuities, equity release and drawdown imaginatively, advisers may find that they can deliver greater certainty and efficiency of outcomes which is great news for their clients, and good business for them

 ¹ “How does spending change through retirement?”, Institute of Fiscal Studies, May 2022